Addressing currency risk in agricultural operations
Matt Dusi, Wells Fargo Sector Manager, Fresh and Frozen Fruits and Vegetables
Fred Stambaugh, Wells Fargo Securities Director, Quantitative Solutions
July 23, 2019
Across the U.S., Wells Fargo’s Agribusiness teams speak with people operating in the industry on a daily basis. Over and over, a consistent theme of risk management plays out within these conversations, along with discussion regarding how farmers and processors are spending time and money in order to reduce their exposure to these risks.
It’s no surprise that an industry as broad and complex as Agribusiness is ripe with risks. The majority of risk encountered by producers and processors can be lumped into the following five high-level categories:
- Production Risks ─ producers face risks related to yield output created by adverse weather conditions at planting or harvest, insect damage, disease, and failure of equipment and machinery; processors face risks related to supply chain inputs, equipment operations, output levels, quality assurance, quality control and food safety
- Marketing Risks ─ related to potential loss of market share or lower than expected prices due to increased numbers of competitors, changing consumer preferences, loss of market access, or failure of a product to meet market standards or packaging requirements
- Financial Risks ─ related to not having sufficient cash to meet expected obligations, generating lower than expected profits, and losing equity in the operation, as well as increased input costs, higher interest rates, excessive borrowing, higher cash demand for family needs, lack of adequate cash or credit reserves, and unfavorable changes in exchange rates
- Legal and environmental risks ─ related to fulfilling business agreements and contracts, liability for injury to another person or property due to negligence, along with environmental liability
- Human resource management risks ─ associated with employees, suppliers, and customers and their relationships with each other, as well as key events with owners such as divorce, death, or disability
Each of the above risk categories and various options to manage the risk can fill an entire article. However, for this article, we’re choosing to focus on a single financial risk that is often overlooked and underestimated, and that is currency risk.
Currency risk – how impactful is it?
In today’s global economy, there are few agribusiness companies of size that are not affected by currency fluctuations, and this is ever increasing due to influences such as a strong U.S. dollar, trade wars, and global political tensions. Whether a canning company purchasing glass jars from China, or a cherry farmer exporting fresh product to Canada, currency exchange rates are having a direct effect on profitability.
Currencies can and have moved by substantial amounts, as a result of country-specific factors, such as devaluation in China, or financial-system factors such as investments in stable/high quality currencies during times of uncertainty. Year-over-year changes of 10-20% + are not unusual.1
The below chart shows the U.S. dollar weighed against a basket of foreign currencies, and the relative strength or weakness of the dollar in the global market over time. Peaking in strength in 2000 and 2001, the U.S. dollar then experienced a prolonged weakening through 2014. Then the U.S. economy gained steam, and the U.S. dollar has moved generally higher since that time. It is worth noting how rapidly, and dramatically, that exchange rates can fluctuate. While this chart reflects a basket of currencies, a chart weighing the U.S. dollar against specific currencies could show even more rapid and dramatic fluctuations, which can significantly impact profitability.
Source: www.investing.com/quotes/us-dollar-index-historical-data; charted by Wells Fargo
Currency fluctuations – advantage or disadvantage?
As with commodity markets, currency movements can either help or harm businesses. If the U.S. dollar goes up, our cherry farmer’s product is more expensive in foreign markets, often reducing demand, encouraging substitutes, or pressuring our farmer to lower his sales price in order to remain competitive. If the U.S. dollar goes down, our cherry farmer’s product is relatively less expensive in foreign markets, increasing the competitiveness, and value, of the product.
A business that sources product in a different country, such as the cannery mentioned earlier, faces the opposite risks. A stronger U.S. dollar means the product is cheaper, giving a boost to profits and a competitive advantage at the margin. A declining U.S. dollar makes the imports more expensive, putting pressure on the cannery to control costs elsewhere, or perhaps look to alternative sources for the needed jars.
Mitigating risk with hedges and options
Farmers also can be subject to indirect risk related to currencies. If a competitor in a given market sees its own currency weaken, it can lower prices and still maintain its margins. And, although the U.S agribusiness may not operate in that currency, the U.S. business might still be exposed to the country’s currency movements.
Agribusinesses are able to hedge currency risks, just as they can hedge commodity price risk, and using similar tools. Forward contracts, similar to futures, allow producers to lock in the current price to secure their purchase/sale price in U.S. dollars, even if the contract is in foreign currency.
Options are also available to provide protection from currency losses, as well as participation in currency gains. Options generally cost a premium for this asymmetric risk profile, but producers can mitigate that expense by structuring hedges that exchange a portion of the potential gains for the protection.
Let’s consider an illustrative example. In August of 2018, a strawberry grower/packer/shipper who purchased berries from Mexico during the winter season would obtain a contract to supply 200,000 flats of strawberries to Kroger at set price of $7/flat for January 2019. At the market price, our producer is paying MXN 95.32 ($5.00) for the Mexico-sourced berries. To insure the $2.00 margin in the transaction (paying $1,000,000 in total), our U.S.-based shipper could do the following:
- Forward contract ─ A forward contract locks in the price for the pesos, so there is no market-driven change to the producer’s peso costs. In this case, forward markets allow a somewhat better price of $973,500, adding a guaranteed $26,500 to the profit margin.
- Option ─ For the same $26,500, the producer could buy an option that locks in the current $1,000,000 cost as a worst case, but allows for a better price if the peso weakens against the U.S dollar.
Currency movements are certainly not the only risk that agribusinesses face when they enter foreign markets. As the last year has proven, trade tensions and tariff policies can abruptly change business conditions. So can other overseas risks, such as political instability, corruption, war, or other conflicts. Nevertheless, the prospect of greater sales is often an inducement to accept these risks. Revisiting our canning company who relies on a Chinese supplier for glass jars, as tariffs are applied to the jars being sourced from China, our canner may need to look to other, less familiar markets to source packaging materials to keep the company’s cost of goods sold (COGS) in line.
Matt Dusi is a Sector Manager on Wells Fargo’s Food and Agribusiness Industry Advisor team with focus on fresh and frozen fruits and vegetables.
Matt re-joined Wells Fargo and the team in August 2016, previously serving as the General Manager of a mid-sized winery and vineyard operation in California, managing all aspects of a premium wine brand. Prior, Matt worked three years as a Wells Fargo Relationship Manager in San Luis Obispo. Matt began his career at Farm Credit West on the Central Coast of California, where he worked for 10 years serving diversified farming operations.
Matt holds a BBA Marketing and Finance from California Polytechnic State University. He is also a graduate of the Pacific Coast Banking School program held at the University of Washington.
Matt lives on the Central Coast of California and is involved with producing wine grapes for premium wine production. He currently serves on the Board of Directors of the Paso Robles Wine Country Alliance, a non-profit, member-funded organization focused on marketing of the Paso Robles viticultural area.
Fred Stambaugh is Director with the Quantitative Solutions group within Wells Fargo Securities. His principal role is to develop quality content for WFS clients for purposes of managing financial and market risk, focusing on strategies that employ FX options.
A veteran with over 30 years’ experience in the FX and FX options markets, Fred has been a thought leader and innovative developer of options hedging strategies dating from the early days of OTC currency options trading. He led the establishment of two money center banks, First Chicago and Chase Manhattan, as global leaders in client FX options trading; he conducted seminars for clients around the world in the use of FX options as hedging tools; he managed client FX risk portfolios totaling $50 billion; and he developed models for dynamic trading of client currency risk.
Fred holds an MBA in Finance from the Thunderbird School of Global Management, an MA in International Relations from the University of Chicago, and a BA in Political Science from Miami University.